WPS6192
Policy Research Working Paper 6192
Sri Lanka
From Peace Dividend to Sustained Growth Acceleration
Daminda Fonseka
Brian Pinto
Mona Prasad
Francis Rowe
The World Bank
Poverty Reduction and Economic Management Network
Policies and International Partnerships Unit
&
South Asia Region
Poverty Reduction and Economic Management Unit
September 2012
Policy Research Working Paper 6192
Abstract
Following the cessation of hostilities in May 2009, the sustain growth rates of 8 percent even when accompanied
Government of Sri Lanka has announced a suitably by a significant rise in total factor productivity growth.
ambitious macroeconomic vision to capitalize on the With the government’s balance sheet constrained by its
peace dividend. Its goals include growing at 8 percent desire to lower public indebtedness, private investment
or more per year and lowering government indebtedness will need to become the engine of growth. This places
from around 80 to 60 percent of GDP by 2015. This high priority on better infrastructure, clear signals
paper’s main finding is that while some post-conflict about the relative roles of the public and private sectors,
bounce is only to be expected, sustaining high growth and hard budget constraints and competition both to
presents significant challenges. A substantial rise in the strengthen the investment climate and spur technological
national investment and savings rates will be needed to upgrading in pursuit of faster productivity growth.
This paper is a product of the Policies and International Partnerships Unit, Poverty Reduction and Economic Management
Network; and Poverty Reduction and Economic Management Unit, South Asia Region. It is part of a larger effort by the
World Bank to provide open access to its research and make a contribution to development policy discussions around the
world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be
contacted at dfonseka@worldbank.org or bpinto2@worldbank.org or mprasad@worldbank.org or frowe@worldbank.org.
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
Produced by the Research Support Team
Sri Lanka: From Peace Dividend to Sustained Growth
Acceleration
Daminda Fonseka, Brian Pinto, Mona Prasad and Francis Rowe1
JEL Classification: E60, E62, E65, O40, O53
Keywords: Peace dividend, long-run growth, national savings, total factor productivity,
government debt dynamics, hard budgets, competition
EPOL
1
The authors are all at the World Bank. This paper is the result of a joint effort between the South Asia
Region (SAR) and the Poverty Reduction and Economic Management (PREM) Anchor of the World Bank
and is part of a broader effort in SAR to understand the drivers of economic growth in Sri Lanka. We thank
Constantino Hevia and Norman Loayza for helpful inputs and comments. The paper has benefited from
helpful discussion at a series of seminars in Sri Lanka during March 2012, including at Colombo, Eastern
and Peradeniya Universities, the Institute for Policy Studies and the Ceylon Chamber of Commerce. The
views herein are entirely those of the authors. They do not necessarily represent the views of the
International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or
those of the Executive Directors of the World Bank or the governments they represent.
I. INTRODUCTION
The cessation of hostilities in May 2009 presents an historic opportunity for Sri Lanka to
embark on an economic trajectory filled with new and abundant promise for all its citizens. In
this paper, we define policy priorities designed to convert the momentum from Sri Lanka‘s peace
dividend into a sustained growth acceleration. By a ―sustained growth acceleration‖ we mean
growing at rates substantially higher than the historical average of 5.0 percent (see Figure 1) for a
prolonged period of time. Indeed, the centerpiece of the government‘s economic vision is
attaining and maintaining a medium-run target of 8 percent growth or more.2
10
Figure 1. Sri Lanka: Real GDP Growth
8
6
%
4
Compound average
2
0
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
-2
Source: Central Bank of Sri Lanka (CBSL)
The economic growth literature distinguishes between growth accelerations that are
sustained and those that are unsustainable (Hausmann, Pritchett and Rodrik 2005). Sustained
growth accelerations are associated with fundamental economic reform, while unsustainable
growth accelerations are associated with positive external shocks and financial sector
liberalization. Nevertheless, both types of growth accelerations are driven largely by
2
In fact, real GDP growth touched 8 percent in 2010 compared to an average of 5 percent over the previous
10 years 2000-09; but this was in part because of a rebound from the effects of the global financial crisis.
Similarly, while growth in 2011 is estimated at a little over 8 percent, the compound average growth rate
over the three years 2009-11 is around 6.5 percent.
2
idiosyncratic, and many times, country specific causes. Moreover, growth accelerations are more
likely for poorer countries, i.e. convergence forces come into play. Perhaps the most encouraging
finding is that growth accelerations are fairly common.
Section II sets out three channels for the peace dividend: reintegration of conflict-affected
areas; macro-fiscal; and microeconomic. While the three channels will interact with and
complement each other, our assessment is that the first two are more likely to contribute to a one-
time positive shift in output levels than a sustained increase in the growth rate. The
microeconomic channel and the private sector are likely to be the most powerful at the margin in
delivering a sustained growth acceleration via an increase in total factor productivity (TFP)
growth. There are two reasons for this: first, the government‘s balance sheet is highly
constrained by its high indebtedness and its desire to reduce this. Second, experience from
countries as diverse as India, Kenya and Poland indicate that profit-maximizing firms operating in
an atmosphere of competition, hard budget constraints and competitive real exchange rates offer
the best hope for upgrading technology and efficiency in pursuit of faster productivity growth.
Import competition has been a particularly important spur.
Section III explores the government‘s debt dynamics systematically—not simply because
the government wants to reduce its indebtedness but because a sustainable fiscal position is a
necessary underpinning for fast, long run growth.3 We show that the impressive reduction in the
government‘s debt-to-GDP ratio between 2002 and 2010 was driven in important part by the
inflation tax on debt, helped by a pick-up in growth. In view of the low inflation target, reducing
indebtedness further must rely much more on sustained and even faster growth.
Section IV presents results from a growth simulation exercise asking what level of
national savings is needed for meeting the government‘s growth target. The results show that a
3
Sustainable debt dynamics and moderate indebtedness reduce macroeconomic uncertainty, lower the
chances of crowding out and create fiscal space both for key public investments as well as allowing
countercyclical fiscal policy.
3
substantial rise in national savings will be needed to deliver 8 percent growth. This will be made
easier by increasing government savings and creating conditions for a big increase in productivity
growth. The private sector will need to play a key role in the latter and this brings us to section V
on the microeconomic foundations of growth. Section VI concludes with a summary of policy
priorities.
The results in this paper are derived from a combination of the Government of Sri
Lanka‘s (GoSL) macro-fiscal vision, cross-country experience from fast-growing economies and
economic theory. GoSL‘s key macro-fiscal targets are as follows:4
 Double per capita income from US $2000 in 2009 to US $4000 by 2016
 Reduce government debt-to-GDP from 81 percent in 2010 to 60 percent in 2015
 Raise government savings from minus 2-3 percent of GDP to plus 1.5 percent
 Aim for inflation based on GDP deflator of 6 percent per year
 Target growth at 8 percent per year over the medium run.
II. CAPITALIZING ON THE PEACE DIVIDEND
In principle, the peace dividend for Sri Lanka would flow through the following
channels:
 Reintegration channel: The reintegration of the war-torn North and East into the economy
would fuel a natural expansion of output.
 Macro-fiscal channel: This would exert positive benefits through two sub-channels. First,
real interest rates on government borrowing would tend to decline along with sovereign risk
premia (see Figure 2) while the currency would tend to appreciate as capital flowed in to take
advantage of ‗undervalued‘ Sri Lankan assets, financial and real. As a result, the
4
Source: Roadmap, Central Bank of Sri Lanka
4
government‘s debt dynamics would improve. Second, the government would be able to
reduce security-related spending and increase development spending.
 Microeconomic channel: Longer business horizons and the falling cost of capital for the
private sector facilitated by growing political stability and fiscal consolidation would
strengthen the microeconomic foundations for growth. Rising confidence would make Sri
Lanka a more attractive destination for FDI, prompt foreign buyers to source more of their
purchases from Sri Lanka and push established domestic businesses to explore diversification
into new areas. The net result would be an increase in investment and faster growth.
Figure2. Sri Lanka: Declining Sovereign Risk
1400
The graph plots the Sri Lankan government bond spread
1200 minus the average emerging market sovereign bond
spread and is meant to capture Sri Lanka specific risk
1000
Basis Points
800
Conflict Ends May 2009
600
400
200
0
2007M11
2008M11
2009M11
2010M11
2011M01
2011M03
2011M05
2011M07
2011M09
2008M01
2008M03
2008M05
2008M07
2008M09
2009M01
2009M03
2009M05
2009M07
2009M09
2010M01
2010M03
2010M05
2010M07
2010M09
2012M01
2011M11
-200
Source: World Bank GEM
The strength of the reintegration channel would depend upon how important the North
and East were in income generation prior to the conflict and how quickly economic activity there
can pick up. Prior to the onset of the war in 1983 the North and East Provinces accounted for a
small share of national output and employment. In 1983, the contribution to national industrial
value added of both provinces was less than 10 percent (approximately 2 percent of GDP), while
5
the employment shares were also less than 10 percent of total employment in the economy.5 The
structure of the economy was dominated by agriculture – 33 percent of total output and 80
percent of employment – and the produce obtained (e.g. onions and chilies) was mainly for
domestic consumption and not for export. More than one half of the country‘s fish catch in 1980
came from the North and the East.
During the war period, it is estimated that the area under cultivation in the North and the
East fell by between 50 and 80 percent, paddy production fell off almost entirely, and industrial
production virtually halted. The bulk of the reduction was concentrated in the North, while paddy
production in the East was essentially unchanged over the period. Migration out of the areas took
place, both to other parts of the Island and to foreign destinations, but the population share of
these areas was still about 13 percent in 2001, although, the depletion of the social and economic
infrastructure during the war means that the human capital stock has fallen behind the rest of the
country. It is also the case that some of the agriculture activities in the North were not totally
abandoned; they simply moved to other areas like Puttalam, and may not be expected to return.
With this background, the contribution of the North and the East to future economic
growth prospects will likely be modest. Reconstruction activities will provide a one-time boost in
growth, but beyond that it seems that small-holder agriculture and the fisheries sector will be the
main sources of continued growth. Looking back at the response in the North and East after the
2002 cease fire agreement can provide some indication of what we might expect. The agriculture
and fishing sectors grew more than 30 percent per year over the 2002-2004 period. The combined
share of paddy production in the North and East increased by 4 percentage points to 31 percent of
national production by 2003. Tourism rebounded in the East with the rebound in tourist arrivals to
all parts of the country. While those developments were impressive in that the growth was broad-
based and likely pro-poor, the small overall share of these provinces in country-wide GDP and
employment meant that they were a modest driver of national growth.
5
The population in the two provinces was about 14 percent of the country‘s total.
6
To exploit the potential of the North and the East, infrastructure would need to be
improved and private investors would need to take an active interest in those regions. This
channel is therefore likely to mesh with the macro-fiscal channels (diversion of security spending
towards infrastructure and reconstruction) and the microeconomic channel.
On the macro-fiscal channel, the relatively closed capital account combined with the
dominant role of state banks acted to keep real interest rates at highly negative levels in the recent
past. Going forward, the effect of falling risk premia on interest rates may be offset by growing
external financial integration, keeping real interest rates at positive levels (as assumed in official
medium-run projections). Therefore, the main macro-fiscal benefit is going to stem from the
ability to reduce security-related spending and reverse the trend decline in revenue mobilization
(in important part by eliminating the tax breaks doled out by the Board of Investment, which
should no longer be needed to compensate for the erstwhile risky environment). This would
facilitate achieving the large increase in public savings needed for sustainable rapid growth.
While falling risk premia may not have large benefits for the government in terms of
lower real interest rates, the impact on the private sector would be beneficial to the extent that it
was implicitly subsidizing the borrowing costs of the government. Overall, given longer horizons
and greater stability, the microeconomic channel could become a powerful channel for the peace
dividend and sustainable long run growth as firms invest in new technology and branch out into
new areas, spurring faster TFP growth.
As noted earlier, the three channels for the peace dividend are linked and complementary.
Eventually, their overall contribution to Sri Lanka‘s growth prospects will depend on
improvements in the country‘s growth fundamentals. Box 1 spells out the ramifications of the
term ‗growth fundamentals‘ for Sri Lanka.
7
Box 1: Growth Fundamentals in Sri Lanka’s Context
In Sri Lanka‘s case, a distinction is worth making between factors which will result in a one-time upward
shift in the level of output and self-sustaining growth as a result of innovation and technological upgrading.
The post-war bounce from reintegration and the full utilization of excess capacity are examples of one-time
positive shifts in output.
To get onto a trajectory of sustained, faster growth, Sri Lanka will need to raise national savings rates and
create conditions for faster TFP growth: an enduring result in the empirical growth literature is that long-
run per capita growth is driven eventually by TFP growth. Cross-country experience indicates that a
sustainable government debt trajectory is a necessary foundation for solid, long-run growth. At the
microeconomic level, competition, especially from imports, and hard budget constraints will provide the
incentive for profit-maximizing firms to adopt new technology, expand their product mix and find new
markets, all of which will contribute to faster productivity growth. At a deeper level, meeting these
requirements calls for good governance and strong fiscal, financial and judicial institutions. These are
needed to ensure well-managed public finances on the one hand and the property rights, level playing field
and predictable environment on the other that will give private firms, domestic and foreign, the confidence
to make long-run investment commitments.
Three other Sri Lanka-specific issues are worth emphasizing:
 The critical importance of good leadership as emphasized in the Commission on Growth and
Development 2009 report, in particular, the assurance of inclusion combined with a long-term
development vision
 Nurturing ethnic peace and social stability
 Taking advantage of Sri Lanka‘s favorable geography in relation to China and India.
III. MACRO-FISCAL UNDERPINNINGS OF LONG RUN GROWTH
GoSL has set itself the target of growing at 8 percent or more per year in real terms over
the medium term in pursuit of doubling per capita income to $4,000 by 2016 starting from $2,000
in 2009. How do the two targets, doubling nominal US dollar GDP per capita and achieving real
GDP growth of 8 percent, mesh with each other? Box 2 goes through the accounting
reconciliation. Its main point is that the doubling of per capita income from $1,000 in 2004 to
$2,000 in 2009 involved a large real appreciation of the Sri Lankan rupee against the US dollar,
of 7.5 percent per year; had the real exchange rate been flat, dollar income would have increased
only by 40 percent and not 100 percent. Looking ahead, keeping up this pace of real appreciation
would almost surely create severe competitiveness problems for Sri Lanka (see Rowe, Mishra and
Rodarte 2011). Fortunately, repeating the above calculation for the period 2009 to 2016 shows
that a flat real exchange rate will achieve a doubling of dollar per capita income provided the real
GDP growth target of 8 percent is achieved. It almost goes without saying that lasting peace is a
8
pre-requisite for improvements in the country's growth fundamentals to realize better
development outcomes (Chen, Loayza and Reynal-Querol 2008). In other words, Sri Lanka will
have to pay close attention to the growth fundamentals outlined in Box 1.
Box 2: Doubling US dollar per capita GDP between 2009 and 2016
Per Capita GDP, US$
3000
2500
2,089
2000
1500
1,032
1000
500
500
0
Source: CEIC data
Sri Lanka took 13 years to double its nominal dollar per capita GDP from US$ 500 in 1991 to US$ 1,000 in
2004. Five years later, in 2009, per capita income had doubled once again to roughly US$ 2,000 as shown
in the figure. The Mahinda Chinthana‘s vision is to achieve another doubling of dollar per capita income by
2016.
To get a better sense of the challenge involved, we use the following identity:
,
where G$ is nominal US dollar per capita growth, g is real GDP growth, is the growth in the bilateral Sri
Lankan rupee-US dollar real exchange rate (defined such that a positive value is an appreciation), is
U.S. inflation and pgr is the population growth (all compound annual average growth rates).
During the period 2004 – 2009, real GDP growth was 6 percent with the population growth rate at 1
percent, implying per capita growth of 5 percent per year. Yet dollar per capita GDP grew at a huge 15
percent per year. Assuming 2 percent US inflation, the above identity tells us that the big driver of G$ was
a rapidly appreciating bilateral real exchange rate, recording an annual average appreciation of 7.5 percent.
Experience from emerging markets the world over demonstrates that sustainable public
finances are an essential underpinning for fast growth. Achieving low inflation rates is not
enough. Public debt has to be on a trajectory deemed sustainable by the markets. Otherwise,
there may be concerns about monetization of the debt and a rise in inflation, which could keep
nominal and real interest rates high. This section starts by discussing broad fiscal outcomes of
the past with a view to better understanding what future fiscal outcomes might look like. Next it
9
looks at the management of the public finances from the prism of debt sustainability and shows
how the underlying determinants of the path of the debt-to-GDP ratio (―debt dynamics‖) are
likely to change quite drastically going forward. In particular, reducing indebtedness further will
have to rely more on faster growth and higher primary fiscal surpluses than on inflation, which
was a prime factor (along with moderate growth) in eroding the government debt-to-GDP ratio
over 2005-08. Lastly, the implications of GoSL‘s medium run fiscal targets for government
saving are discussed.
a. A Brief History of Fiscal Policy in Sri Lanka
Before 1977, Sri Lanka‘s development strategy was based on import substitution with the
government aiming to create a comprehensive welfare state. Its enviable social development
indicators for its stage of development testify to the importance placed on social expenditures in
the budget. An extensive network of welfare expenditures and consumer subsidies was paid for
with trade tax revenues. In 1985, export taxes and import tariffs made up 30 percent of revenues.
Fiscal outcomes in Sri Lanka over the past three decades display three main features.
First, revenue from trade taxes has been in secular decline since 1985, reaching 18 percent of
revenues in 2010 as a result of the post 1977 reforms, which liberalized external trade. Falling
trade taxes led to falling fiscal revenues: government revenues as a share of GDP declined from
23 percent in 1980 to just 14 percent in 2010. The good news is that the 2011 Budget has
initiated a systematic effort to increase revenue mobilization through new tax instruments and
improved tax policy, including by revisiting the tax breaks provided by the Board of Investment
(BOI).
Second, government subsidies to both consumers and state owned enterprises have been
consistently significant in expenditures, ranging from 4 to 7 percent of GDP over the years.
Third, since the outbreak of the conflict in 1983 defense expenditures have consumed an
ever-growing share of total expenditure. With social expenditure and subsides being protected,
capital spending has borne the brunt of cuts after 1980 to keep fiscal deficits under control
10
(Figure 3). However, these cuts were not enough to offset the decline in revenues, resulting in a
fiscal deficit that has averaged 10 percent over the last thirty years.
Figure 3. Sri Lanka: Drivers of Fiscal Outcomes
(a). Government Revenues and Capital Expenditure (1977-2010) (b). Sri Lanka: Overseas Development Assistance (ODA) and Military
(As a percent of GDP) Expenditures ( % of GDP)
30 30 14 7
12 6
25
25
10 5
20
8 4
20 15
6 3
10
4 2
15
5
2 1
10 0 0 0
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Revenues-L/Axis Capital Expenditure-R/Axis ODA-L/Axis Military Expenditures-R/Axis
Source: CBSL
A direct consequence is that interest costs have grown from 4.6 percent of GDP in 1985
to an average 6 percent of GDP for much of the recent decade. Rising interest costs started to kick
in during the 1990s when there was a dramatic fall in concessional sources of financing as the
conflict intensified. Overseas development assistance fell from on average 8.5 percent of GDP in
the 1980s to just 2 percent of GDP by 2000, as shown in Figure 3 (b). Non-concessional external
debt and much more expensive domestic debt became the main sources of financing in these
years, helping to drive up both the stock of debt and interest costs.
b. Debt Dynamics
We focus on government debt dynamics since the late 1990s, which have been driven by
the interaction among aid inflows, the conflict, inflation and economic growth outcomes. Going
forward, debt dynamics are likely to be quite different from the historical evolution described
here. In particular, faster growth and raising primary fiscal surpluses will need to be the focal
points if Sri Lanka is to attain its goal of reducing government indebtedness to 60 percent by
2016.
11
Figure 4 plots the ratio of government debt to GDP (―debt ratio‖) from 1997 to 2010. It
peaked at 106 percent in 2002 after rising by some 23 percentage points of GDP starting in 1997.
It then fell by some 20 percentage points between 2002 and 2009.
Figure 4. Government Debt and Fiscal Deficit (1997-2010)
( % of GDP)
12 120
10 100
8 80
6 60
4 40
2 20
- 0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Foreign currency debt/GDP Rupee debt/GDP Fiscal Deficit (left axis)
Source: CEIC data.
To get a better sense of the underlying factors driving this debt trajectory, we carried out
a decomposition exercise aimed at apportioning changes in the debt ratio over the period 1998-
2010 to the primary fiscal deficit, real GDP growth, the real interest rate and the real exchange
rate.6 In addition to these main drivers of debt dynamics, the effect of revenues from
privatization (‗divestment‘) and other, unidentified factors are shown in the last two rows of
Table 1. The way to interpret the numbers in the table is as follows: the first row gives the actual
change in the debt ratio for each sub-period in percentage points of GDP per year (the reason for
such ―annualization‖ is that the sub-periods are not equal in length). For example, over 1998-
2004, debt increased by an average rate of 2.8 percentage points of GDP per year, while it fell by
some 3 percentage points per year over 2006-08. The numbers in the other rows give the average
annual impact of each underlying factor for each sub-period in percentage points of GDP: a
6
The technical details and derivations can be found in the appendix to Aizenman and Pinto (2005).
12
positive (negative) number means that the factor concerned raised (lowered) the debt ratio during
that sub-period.
a/
Table 1 : Factors Explaining Government Debt to GDP Path
1998-2004 2005 2006-08 2009-2010
Change in Government Debt / GDP 2.76 -11.72 -3.08 0.28
Underlying factors:
Primary balance 2.17 2.13 1.95 2.55
Real GPD growth -3.79 -6.01 -5.62 -4.57
Real Interest Rate 1.68 -1.36 -1.11 2.49
Real Exchange Rate 0.81 -3.92 -1.98 -2.48
Privatization -0.3 -0.04 0 0
Other factors 2.19 -2.84 3.58 2.30
a/
The numbers in the table are the average annual impact of each factor for each sub-period of time in percentage
points of GDP.
Source: CBSL Annual Reports, Bank staff calculations.
If we compare the debt build-up phase, 1998-2004 (when debt rose sharply and stayed
above 100 percent of GDP until 2004) with the subsequent rapid decline over 2005-2010:7
 The primary fiscal deficit hovered around 2 percent of GDP—there was not significant
change here
 Faster growth over 2005-2010 resulted in an additional erosion in the debt ratio equal to 1.5
percentage points of GDP per year (-3.8 over 1998-2004 compared to -5.3 over 2005-2010)
 Combined real interest rate and real exchange rate impact went from +2.5 percentage points
of GDP over 1998-2004 to -2.4 percentage points over 2005-2010, a swing of close to 5
percentage points per year. This was the biggest factor by far and explicable largely by a
pick-up in inflation, as we shall see below.
Almost half of the 24 percentage point reduction in the debt ratio between 2002 and 2010
occurred that year, which followed the devastating tsunami of December 2004. Nominal interest
rates dropped significantly and the currency appreciated in nominal and real terms as aid inflows
7
These observations are based on comparing the numbers for 1998-2004 with those for 2005-2010. The
reason for splitting up the latter period in Table 1 will become apparent below.
13
surged by 2 percentage points of GDP. Inflation rose to double-digit levels. The drop in real
interest rates to negative levels and the appreciation of the real exchange rate explain almost half
the fall in the debt ratio that year; while a pick-up in growth as tsunami-related reconstruction
began explains the rest of the decline.
After 2005, ODA flows declined, the conflict intensified and domestic inflation started to
accelerate in part due to the international food and fuel prices crisis of 2007-08. Real exchange
rate appreciation and a decline in real interest rates continued to play an important role in
reducing the debt ratio during 2006-08. Again, robust real GDP growth pulled the ratio in the
same direction, while the primary deficit acted to halt an otherwise bigger decline in the ratio.
The years 2009-10 are isolated for two reasons. First, these years reflect the impact of the
global financial crisis on Sri Lanka and the subsequent rebound from it; growth fell to 3.5 percent
in 2009 and then accelerated to 8 percent part of which may be explicable by the peace dividend.
Second, these years provide the first hint that the debt dynamics in Sri Lanka are about to change
in fundamental ways. Overall, the debt ratio remained largely unchanged from its 2008 level of
81 percent of GDP. As in the previous two periods, the strong appreciation of the real exchange
rate reduced the debt burden, but unlike in the past, the real interest rate effect increased it by an
almost offsetting amount.
c. Role of Inflation
This brings us to a critical point: inflation has played a significant role in reducing the
debt ratio since 2005. Figure 5(a) depicts the composite real interest rate over the period 1998 to
2009; the composite real interest rate captures the joint impact of real interest rates and the real
exchange rate on total indebtedness, foreign currency and rupee.8 It was consistently positive
8
See technical annex for derivation. The advantage of working with the composite real interest rate is that
it readily enables a comparison with the real interest rate used for projections of the debt ratio into the
future—which are often done in a single currency environment (note that Table 1 separates the real interest
rate and exchange rate effects).
14
until 2005, when it entered strongly negative territory as inflation picked up during the years
2005-08 and became a major factor in the erosion of the debt ratio.
Figure 5. Sri Lanka: Inflation and Debt Dynamics
(a). Composite Real Interest Rate ( 1998 - 2010) (b). Inflation tax on debt (% points of GDP)
8 14
6 12
Actual Inflation Tax
4 10
2
8
%
-
6 Inflation tax if p=6%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 p= % change in GDP deflator
(2)
4
(4)
2
(6)
-
(8) 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Bank staff calculations Source: Bank Staff Calculations. For definition, see text.
Figure 5 (b) depicts the implicit revenues secured by GoSL from inflation, labeled
―inflation tax on debt‖, which averaged a huge 9 percentage points of GDP per year over the four
years 2005-08. There is no free lunch: if inflation persists, rational investors in government
securities would soon demand higher nominal interest rates and the rupee would tend to
depreciate, reducing the effective proceeds from the inflation tax. For example, the proceeds
from the inflation tax on debt were close to 12 percent of GDP in 2001 but neutralized by high
nominal interest rates and a large depreciation of the rupee (leading to a zero composite real
interest rate as shown in Figure 5(a)). But this was not the case over 2005-08, leading to large,
negative composite real interest rates over this period. Three reasons for the relatively muted
response of nominal interest rates and the exchange rate might be the large inflow of foreign aid
after the tsunami; the dominant role of state banks in the domestic government debt market
combined with the unseemly optics of demanding high nominal rates during a war effort; and the
relatively closed capital account, limiting the menu of alternative investments.
Going forward, the situation promises to be dramatically different. The composite real
interest rate being assumed by GoSL in its medium-term program is plus 3 percent, indicating
that it is not banking on negative real interest rates. This incorporates a major switch in the
15
government‘s debt dynamics. The Central Bank has also announced a medium-term target of 6
percent for the GDP deflator. The implications of this are captured by the dotted line in Figure 5
(b), which computes the inflation tax at the target rate of 6 percent. The difference between the
two graphs is a measure of the ‗excess‘ inflation tax on debt over this historical period, which
shrank dramatically in 2009 as inflation fell to single-digit levels. With the Central Bank‘s single
digit inflation target for the medium-term and a more-or-less flat real exchange rate, the
expectation of positive real interest rate going forward is well founded.
Additionally, the central bank is engaged in a systematic opening up of the capital
account ( Box 3). This too will limit the ability to use the inflation tax as investors will now have
alternatives, increasing the inflation elasticity of rupee-denominated assets. Therefore, going
forward, one should expect a sharply reduced role for inflation in curbing indebtedness. In other
words, reducing indebtedness to 60 percent of GDP is going to require faster growth and fiscal
reform to raise primary fiscal surpluses.
Box 3: Financial Liberalization – Growth or Vulnerability?
The goal of the financial system is to help with resource mobilization and allocation as well as risk
management in pursuit of faster long-run growth. It can, however, itself become a costly source of
vulnerability. In particular, emerging economies pursuing open capital accounts and external financial
integration have often found that the eventual result was higher macroeconomic vulnerability than faster
growth. Vulnerability was more apt to take hold in countries where public finances were weak, exchange
rates fixed, international liquidity low (low foreign exchange reserves relative to the claims on them) and
current account deficits large.
At the same time, emerging market countries like India and China, which are growing rapidly, have moved
cautiously on external financial integration and relied substantially on national savings in order to finance
investment and growth.
Sri Lanka has an excellent credit history: it has never defaulted on its debt even during the long civil war.
Risk premia have fallen sharply following the end of the war (see Figure 2) and growing confidence in
economic policy. GoSL has announced a medium-term plan to lower its fiscal deficit and the government‘s
debt-to-GDP ratio.
Armed with these strengths, CBSL has embarked upon an extensive liberalization of the capital account.
Experience indicates that this program needs to be implemented cautiously. While there has been a
substantial build up in foreign exchange reserves under the IMF program, these were less than short-term
external debt at the end of 2011. And the equivalent of some $2.4 billion in government securities issued in
the domestic market is held by foreign portfolio investors—although a cap of 12.5 percent has been placed
on foreign investment in the government debt market.
16
d. Fiscal Targets and Government Saving
As stipulated in the Fiscal Management (Responsibility) Act No 3 of 2003, GoSL
announced its medium-term macro fiscal framework in November 2010 covering the period up to
2013, in which it intends to maintain government capital expenditure at 6.5 percent of GDP while
lowering the fiscal deficit to 5 percent of GDP by 2013. These targets imply significant
challenges for the management of the public finances as can be readily seen from the accounting
identity in equation (1). Equation (1) says that the fiscal deficit is simply the difference between
government investment (annual capital expenditure) and government saving (revenue minus
current spending):
(1) ,
where the left hand side is the ratio of the fiscal deficit (total expenditure G minus total revenues
T) to GDP and IG and SG are government capital expenditure and saving respectively. If the fiscal
deficit is to be brought down to 5 percent of GDP while capital expenditure is kept at 6.5 percent
of GDP, it follows from (1) that government savings will have to be raised from the current levels
averaging minus 2 to 3 percent to plus 1.5 percent, a significant swing of 3.5 to 4.5 percentage
points of GDP in very short order.
A similar effort is needed to ensure that government debt falls to 60 percent of GDP by
2015. This will require the primary surplus to be raised from minus 2 percent of GDP on average
over the last decade to zero immediately followed by a gradual increase to a little over 1percent
of GDP by 2015.9 Slower growth or higher real interest rates will require a bigger fiscal effort.
In the next section, we focus on long-run growth dynamics and the sustainability of the
post-conflict growth acceleration.
9
This calculation assumes a linear reduction in the debt ratio from 81 percent in 2010 to 60 percent in
2015, a real interest rate of 3 percent and real GDP growth of 8 percent per year. Once the goal of 60
percent is reached, Sri Lanka will be able to run primary deficits of close to 3 percent of GDP yet maintain
the 60 percent debt ratio; but this crucially rests on the persistence of a differential of 5 percentage points
between the real growth rate and real interest rate and the desirability of keeping the debt ratio at 60
percent.
17
IV. SUSTAINABILITY OF HIGH GROWTH
This section sets out the challenge of sustaining the high growth rates. As a starting
point, Box 4 lays out the ―growth arithmetic‖ commonly used to ascertain the savings rates Sri
Lanka would need to fulfill its growth aspirations. While this framework is helpful in assessing
the savings effort needed from the public and private sectors to achieve economic growth targets,
the arithmetic runs into trouble because it assumes a constant incremental capital-output ratio
(ICOR), which is equivalent to assuming constant marginal returns to capital. In practice, with
capital subject to diminishing marginal returns, the savings rate needed to support a target growth
rate will rise over time for given total factor productivity, labor force and human capital growth
rates. For the same reason, we would expect to see an increase in the ratio of capital to output
over time. Therefore, a dynamic framework allowing for diminishing marginal returns to capital
is needed to get a better sense of the medium-to-long term links between savings and growth.
Box 4: Harrod-Domar Growth Arithmetic: Simple, but Incomplete
Numerical calculations of the savings rate needed to support a target growth rate are commonly carried out
using the Harrod-Domar equation. This equation can be obtained as follows:
,
where g is the growth rate of real GDP, Y, and K is the physical capital stock. The first term in brackets on
the right-hand side is the inverse of the incremental capital-output ratio (ICOR) while the second is the
investment rate. The simplest version of the framework assumes a closed economy so that the investment
rate equals the savings rate, s. Therefore, given a target growth rate g*, the required savings rate s* based
on the equation is the ICOR multiplied by g*.
Given the Sri Lankan real GDP growth target of 8 percent and an ICOR of 4.5, the required investment rate
would be 36 percent of GDP. If one assumes a sustainable current account deficit of 4 percent of GDP,
then the required national savings rate s* would be 32 percent. Suppose the ICOR goes down to 4 as a
result of growing productivity and efficiency as part of the peace dividend. Then s* would fall to 28
percent.
With national savings averaging 22 percent of GDP over the last decade, the increase in the savings rate
would need to be 6 percent of GDP. Achieving the fiscal target of raising government savings from -2
percent to +1.5 percent of GDP would require an increase in the private savings rate of an additional 2.5
percent of GDP, which is eminently feasible.
While this appealing framework indicates that a target growth rate of 8 percent is readily within grasp, it is
subject to pitfalls beyond the very short run. These are discussed in the text.
With this in mind, we present results below drawn from a dynamic simulation framework
calibrated with parameters and data drawn from Sri Lanka‘s own past experience as well as that
18
of other developing countries using a modified Solow growth model.10 In this model, growth is
driven by the following main variables:
 Total Factor Productivity (TFP) growth: The growth rate of TFP is exogenous in the
simulation framework. Historically, it has averaged around 1 percent per year in Sri Lanka.
In Scenario 1, it is assumed to accelerate to 1.75 percent, which represents a substantial
increase. A further acceleration to 2.5 percent is assumed under Scenario 2, a TFP growth
rate few countries exhibit over long periods.11
 Capital accumulation: The capital-to-output ratio for 2010 is determined by the perpetual
inventory method with an assumed 8 percent depreciation rate (details may be found in Hevia
and Loayza 2011, henceforth, H-L). The subsequent dynamics of the capital stock are
determined by the path of national savings and the current account deficit with suitable
adjustments for depreciation.
 Savings: National savings is the sum of private savings and government (public) savings.
Private savings is treated as endogenous and depends upon income and demographic
variables (such as the ratio of old-age or young-age population to working age population) as
well as public saving (through so-called Ricardian effects). Public savings could either be
given as a policy variable (as determined by the announced fiscal targets, for example) or as a
balancing figure needed to attain a required national savings rate.
 Labor force and Human Capital growth: The ratio of working age population to total
population (―labor force‖) is based on demographic projections while the quality of the work
force (―human capital‖) is determined in accordance with the number of years of schooling
and the returns to education. Both variables are exogenous.
 External sustainability: The simulation framework assumes that Sri Lanka will be able to
increase net external indebtedness along a path which yields a sustainable current account
deficit in the 4 percent of GDP range.
The simulation framework (Annex 2 presents the underlying equation) is used to answer
two types of questions: what is the national savings rate needed to support a given growth target?
And for a given target for public savings, what growth path will emerge? Figure 6 summarizes
the results from Scenario 1 with 1.75 percent TFP growth. Panel (a) shows the national savings
10
The framework and detailed results are contained in Hevia and Loayza (2011).
11
As Hevia and Loayza (2011) note, 1.75 percent is the average TFP growth rate in the top 25 percent of
countries in a worldwide sample; 2.5 percent would constitute a ―miracle‖ scenario.
19
trajectory required for 8 percent real GDP growth (which translates to 7.2 percent per capita
growth) over 2011-2015. The national savings rate has to increase to 41 percent by 2015 in order
to deliver this growth rate.
Figure 6. Growth Scenario 1
TFP Growth 1.75 percent
GDP Growth per Capita Target = 7.2% over 2011-2015
(a). (b).
0.45 10.0%
0.40
0.35 8.0%
0.30
0.25 6.0%
0.20
0.15 4.0%
0.10
2.0%
0.05
0.00
0.0%
-0.05 2010 2015 2020 2025 2030
2010 2015 2020 2025 2030
National Saving Private Saving Public Saving Per Capita GDP Growth GDP growth rate
Source: Hevia and Loayza (2011)
How will the required savings rate of 41 percent for Sri Lanka be split between private
and public savings? With private savings determined endogenously, most of the action will need
to come from raising public savings, as shown in the figure. Public savings will need to increase
from negative levels in 2010 to close to 20 percent of GDP in 2015 and eventually plateau around
23 percent of GDP. Going beyond 2015, the simulation assumes that the 41 percent national
savings rate will be maintained into the future. However, as a consequence of diminishing
marginal returns to capital, the growth rate of GDP declines to 4 percent by 2030 even if the
savings rate of 41 percent is maintained. Indeed, to keep real GDP growth at 8 percent over the
long run, the national savings would have to continuously rise above 41 percent. Box 5 provides
an explanation for why the savings rate must keep rising to achieve a given growth target.
20
Box 5: Why the Savings Rate Must Keep Rising with a Given Growth Target
Why must the savings rate rise continuously in the neoclassical framework underpinning the Hevia-Loayza
simulation model to maintain a target growth rate? With the growth rates of TFP, human capital, the labor
force, and population given exogenously, (let‘s refer to their sum as z), the only way for the growth rate of
GDP to stay constant at some target level is for the capital stock to grow at a constant rate. For this to
happen in the presence of diminishing marginal returns to capital, a fundamental assumption in the
neoclassical framework, the savings rate must continuously increase.
Let output, Y, be given by: where A is TFP, K is the stock of physical capital, E is the
working age population (―number of workers‖) augmented by the human capital variable, , to obtain
effective labor input, and is the elasticity of output with respect to capital ( being less than 1
implies diminishing marginal returns to capital). Then we can write the growth equation:
(i) ,
where a ―^‖ refers to the growth rate of a variable: is the growth rate of output, is the growth
rate of the capital stock, is TFP growth, and is the growth rate of human capital. We can write
where is the ratio of working age population, E, to total population, N, which then gives
, where is the population growth rate, completing the expression on the right-hand-side of
equation (i). The expression in square brackets is the z referred to in the first paragraph of this box.
It follows from (i), for a given z and target growth rate , that must satisfy:
(ii) .
In other words, the capital stock must grow at the constant rate given by this equation. Now
where s is the national savings rate, c (assumed constant) is the ratio of the current
account deficit to output, and is the rate of depreciation of capital. This can be rewritten:
(iii)
Combining (ii) and (iii) gives us an expression for the required savings rate, s*, to meet a given growth
target, g*:
(iv)
In equation (iv), K/Y is the reciprocal of the average product of capital, APK. Since APK goes down with
K because of diminishing marginal returns (recall that APK is proportional to the marginal product of
capital with the Cobb-Douglas production function assumed for Y) it follows from (iv) that s must rise over
time to maintain growth at its target level of g*.
Two corollaries emerge from the above:
 Suppose the savings rate is raised to meet a given growth target in line with (iv) and then held constant.
In this case, growth will slow until it reaches its steady-state value given by along a
balanced growth path (meaning that the capital stock grows at the same rate), that is, the asymptotic
growth rate of GDP is determined by TFP growth, human capital and population growth (the
assumption is that the ratio of working age population to total population eventually stabilizes). Using
(i), it follows that in steady state, , which is simply a
way of decomposing the expression for steady-state growth earlier in this bullet into components
attributable to TFP, capital accumulation, human capital and population growth (as in Table 2 below).
 Any forces which lead to non-diminishing marginal returns to capital (―endogenous growth‖) will
obviously be beneficial and require a lower savings rate for a given growth target. (Some of this is
discussed in section V on the microfoundations of growth.)
21
Notice from Figures 7(a) and (b), which show savings and growth rates for China and
India, that the need for high savings rates for sustained fast growth is hardly extravagant.
Figure 7. National Savings and Growth: China and India
(a). China: Growth rate and Savings Rate (b). India: Growth rate and Savings Rate
18 60 12 40
16
10 35
50
14
30
12 8
40
25
10
%
%
6
%
%
8 30 20
4
6
15
20
4 2
10
2
10
0 5
0
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
-2 0 -2 0
Growth rate-L/Axis Gross Savings/GDP - R/Axis Growth rate-L/Axis Gross Savings/GDP - R/Axis
Source: World Bank WDI data Source: World Bank WDI data
This exercise brings out two points: first, achieving 8 percent growth over the medium
term in Sri Lanka will call for a huge fiscal effort to increase public savings substantially.
Second, even assuming the required level of savings is achieved, it will not suffice to maintain an
8 percent growth rate over the long run. Since achieving the desired level of public savings may
not be feasible, Figures 8 (a) and (b) shows the growth dynamics consistent with the targeted
level of public savings of 1.5 percent of GDP to be attained by 2012. This will constrain the
overall level of national savings to a little over 25 percent of GDP in the medium run, leveling off
at just below 25 percent over the long run. Sri Lanka does not reach the 8 percent growth target
even over the medium run and the growth rate drops to less than 4 percent over the longer run.
Figures 9 (a) and (b) depict Scenario 2 reconciling the government‘s growth targets with
its savings target of 1.5 percent of GDP. The key difference from the previous simulation is the
assumption that TFP will grow at 2.5 percent per year over the long term. Based on cross-
country experience, this is not impossible but is hard to achieve: this is a highly optimistic
scenario. National savings need to rise to approximately 27 percent over the long-term; recall
from Figure 7 that this is substantially less than the savings rates achieved by China and India.
22
Real GDP growth is maintained at the 8 percent target until 2014 and then declines although it
stays above 6 percent until the end of the decade. Eventually, it settles at a rate which is similar
to Sri Lanka‘s historical average growth rate of 5 percent.
Figure 8. Growth Scenario 1 With Government Savings of 1.5% of GDP
TFP Growth 1.75 percent
(a). (b).
0.30 8.0%
0.25
6.0%
0.20
0.15
4.0%
0.10
0.05 2.0%
0.00
2010 2015 2020 2025 2030 0.0%
-0.05
2010 2015 2020 2025 2030
National Saving Private Saving Public Saving Per Capita GDP Growth GDP growth rate
Figure 9. Growth Scenario 2
TFP Growth 2.5 percent
Public Saving / GDP = 1.5% by 2013
(a). (b).
0.30 10.0%
0.25
8.0%
0.20
6.0%
0.15
0.10 4.0%
0.05
2.0%
0.00
2010 2015 2020 2025 2030 0.0%
-0.05
2010 2015 2020 2025 2030
National Saving Private Saving Public Saving Per Capita GDP Growth GDP growth rate
Source: Hevia and Loayza (2011)
23
Table 2 illustrates the challenges inherent in the long run growth dynamics when the
public (government) savings rate is constrained. It presents a decomposition of the various
factors contributing to growth in the Optimistic Scenario with government savings rising to its
target of 1.5 percent of GDP. One of the striking features is the negative contribution to growth
from the labor force for most of the simulation period because the working age population is
expected to experience a decline until at least 2020.
Table 2. Sri Lanka: Growth Simulation results with TFP g=2.5%/year and
Government Savings reaching 1.5% of GDP by 2012
Year
2012 2015 2020 2030
Real GDP growth 8.1 7.1 5.7 4.7
GDP per capita growth 7.3 6.4 5.3 4.5
a
Contribution to per capita GDP growth
TFP 2.5 2.5 2.5 2.5
Physical Capital 4.6 3.8 2.7 1.8
Human Capital 0.2 0.3 0.2 0.2
Labor Force -0.1 -0.1 -0.1 0.0
Source: Authors' calculations based on Hevia and Loayza 2011.
a
Percentage points
In sum, the realization of an 8 percent growth rate sustained over the long term will
require significant increases in the national savings rate. Achieving high rates of TFP growth and
increasing government savings beyond levels currently contemplated will make it easier to
achieve the required savings rates—the first by lowering the need for capital accumulation and
hence the savings rate itself; and the second by putting less pressure on private savings rates.
Such effort will help offset the diminishing returns to capital and adverse effects of Sri Lanka‘s
demographics. The challenge then is to create conditions conducive to large and sustained
productivity improvements in the context of lower public indebtedness and an attractive
investment climate. The next section discusses the micro foundations of growth.
24
V. MICRO-FOUNDATIONS FOR SUSTAINED GROWTH
The private sector investment response in the post-conflict era is hugely important for a
simple reason: the government‘s role in additional investment is constrained by its balance sheet
and the medium-run fiscal and debt targets it has announced. As noted in the introduction, the
peace dividend is likely to have some of its strongest echoes in improved growth fundamentals
reflected eventually in the emergence of internationally competitive firms and banks. We briefly
touch upon four areas that are vitally important for this link to be firmly established and thereby
generate a sustained growth acceleration.
a. Credibility and Signaling
In any situation involving a big change, the private sector, foreign and domestic, is going
to ‗wait and see‘. Three main reasons seem to explain the ‗wait and see‘ observed post-conflict in
Sri Lanka. First, based on informal interviews conducted for this study, few expected the war to
end so quickly. Second, investors want positive signals from the government: key signals are
discussed below. Third, the external environment is uncertain. Global growth is expected to
slow in 2011 and Sri Lankan exports are heavily dependent upon the USA and EU. Besides, the
Euro periphery is mired in a debt crisis.
A huge advantage GoSL has in creating an enabling environment for sustained rapid
growth is its big political majority. This enables the government to be decisive in creating an
attractive environment for private business and going for some quick wins to signal its intentions.
Indeed, positive signals have already been transmitted via the 2011 Budget with its list of tax
reforms and plans to clarify the role of the Board of Investment and the release of the Central
Bank‘s Roadmap. The 2011 Budget has been extolled both for its content and maintaining
continuity with the 2010 Budget and the medium-term fiscal and debt targets. The challenge is to
establish the credibility of the signals through decisive implementation of the adopted macro-
fiscal framework.
25
A critical positive step is the reduction in marginal tax rates from 35 to 28 percent for
corporate income, the reduction of personal income taxes and the extension of income tax to
public servants. The VAT has been reduced from 22 to 12 percent and from 20 to 12 percent for
the financial sector. The decision to bring public sector employees into the tax net was widely
praised as promoting a ―tax culture‖.
Areas where the private sector is seeking clarity include:
 Relative roles of the public and private sector: A clear policy statement and consistent
adherence to it regarding the role of the state in economic activity will be needed to provide
an unambiguous signal to domestic and foreign investors that the private sector will be the
future engine of economic growth in Sri Lanka.
 Role of the Board of Investment: Many remarked that with the end of conflict, the Board of
Investment will need to reinvent itself. In particular, the need for ad hoc tax breaks will
diminish. However, the precise role to be played by the BoI needs to be defined.
The big majority of the government also enables it to take decisive steps in promoting
ethnic peace and healing. The criticality of social and ethnic peace in promoting long-run growth
is demonstrated in several empirical studies, e.g. Rodrik (1999). Reconstruction, ethnic healing
and the restoration of trust are likely to take several years, calling for a sustained effort.
b. Private Investment Incentives
The general decline in country risk in the immediate post-conflict environment should
lower the cost of capital for domestic firms, while the adoption of sound policies should lengthen
investment horizons for both domestic and foreign investors. The positive impact can be shown
by the equation:
(2)
26
which captures the standard condition that profit maximizing private investors will invest until
the marginal product of capital MPK equals the real interest rate, r, plus depreciation, . In a
conflict environment, the right-hand-side would also include a premium to compensate for the
associated risk. On the assumption of diminishing marginal returns to capital, this would lower
the optimal capital stock and therefore investment. Reducing or eliminating this risk premium
would have the opposite effect and increase investment. Similarly, the lengthening of horizons
would enlarge the set of potential investments firms would consider, some of which may take
several years to reach break-even volumes or involve set-up costs in introducing and marketing
new products—considerations that would not be appealing in a conflict situation. Companies are
likely to be induced to implement projects put on hold during the conflict while foreign investors
could be expected to pay more attention to the country.
However, the above will only lead to a one-time positive effect on output. The real gains
to Sri Lanka will come from a sustained increase in productivity as a result of technological
upgrading catalyzed by the falling cost of capital and rising returns to private capital at least for a
period. This can be shown by the formalism:
(3)
where the right-hand-side lists the variables that the MPK depends upon: total factor productivity
or technology, TFP; human capital, HK; public investments, including those in infrastructure, IG;
and an index of externalities, which could include positive spillovers and agglomeration effects
and promote endogenous growth.12 By raising the marginal returns to capital, these factors can
play a major role in stimulating investment. Some of these factors have a public good
characteristic, importantly, investments in infrastructure and human capital, which could be
facilitated by reduced public spending on security as part of the peace dividend. But there is also
a private aspect: firms could upgrade their technology confident that their property rights will be
12
This formalism is similar to equation (4), page 8, in Hausmann, Rodrik and Velasco (2005).
27
protected and that a lasting peace will prevent any disruption of operations or damage to fixed
assets. However, they will need incentives to do so, and experience shows that firms are more
likely to invest when in better technology and raise productivity when there is pressure on their
profit margins and they realize that (apart from the promise of strong institutions, the protection
of property rights and reliable infrastructure) there will be no special help forthcoming from the
government. In other words, when hard budget constraints and competition, both from domestic
and foreign sources, are present.13 Box 6 discusses competitiveness in Sri Lanka (with more
details in Annex 3), while the next section focuses on hard budget constraints for state-owned
enterprises.
Box 6. Sri Lanka: A Survey of Constraints to Doing Business
A scan of the recent survey-based indicators of the business climate and overall competitiveness in Sri
Lanka reveals a promising outlook for the business environment provided the commitment to implement
stated government policy remains strong. The main take away from the survey-based evidence is that
macroeconomic policy constraints have been consistently at or near the top of the main constraints to doing
business in Sri Lanka.
Sri Lanka ranks 89 out of 183 countries in the World Bank Group‘s overall ―Doing Business‖ rankings in
2012, with tax policy being long considered a major drag on private sector investment. The same result
comes out when looking at recent Global Competitiveness reports. Sri Lanka ranks 62 out of 139 countries
in the overall Global Competitiveness Index (GCI) 2010-11. Sri Lanka seems to be lagging in terms of
Macroeconomic environment, especially when it comes to Government budget balance, Government debt,
and Country credit rating. Labor market efficiency and Technological readiness come out quite low (Sri
Lanka ranks 128, 111 and 85 out of 139 countries respectively).
The emergence of internationally competitive firms in Sri Lanka will also depend importantly on the trade
regime. Here too the conclusion is that it is squarely in the hands of the government to improve the trade
regime. Although Sri Lanka is not an outlier, the transactions costs of trading across borders are
significantly higher than in comparator countries. Bureaucratic procedures rather than infrastructure-
imposed or technical constraints are the major source of high transactions costs incurred by exporters and
importers alike. Redundant regulations and red tape as well as outdated customs procedures that are not
compatible with requirements of modern trading are impeding the participation of Sri Lankan firms in more
sophisticated forms of division of labor based on production fragmentation or global value chains.
c. Hardening Budget Constraints for State-owned Enterprises
Hardening budget constraints for state-owned or public enterprises (PEs) is important for
two reasons: the first is that they can help contain the fiscal burden. Transfers from the budget
13
Some of the clearest evidence on the efficacy of hard budgets and competition comes from the transition
countries of Central and Eastern Europe. See Pinto, Belka and Krajewski (1993), Carlin, Fries, Schaffer
and Seabright (1999) and chapter 7 of European Bank for Reconstruction and Development (1999).
28
(capital and recurrent) to public enterprises have averaged 1.5 percent of GDP or 6 percent of
total expenditures in recent years. The stock of debt held by PEs adds to the fiscal burden, as does
the issuance of government guarantees to support PEs. The Ceylon Electricity Board‘s (CEB)
electricity tariffs have always been below the cost of production, forcing it to finance most of its
operations with debt. The Ceylon Petroleum Corporation (CPC) is the largest importer of oil in
the country, accounting for about 20 percent of total imports and 5 percent of GDP. The CPC
subsidizes the CEB, transport utilities and other government departments implying that the CPC
is also forced to borrow for its operations. These circular debts and government guarantees
amounted to 3.25 percent of GDP in 2010.
The second reason is related to the first: to ensure that PEs involved in infrastructure
provision or carrying out public investments do so efficiently, as this would enhance the
profitability and attractiveness of private investment. The Government has recently taken
measures to raise efficiency in CEB and CPC. CPC is expected to run a small surplus this year
resulting from price increases and measures to improve operational efficiency. The outlook for
medium-term term losses at the CEB appear contained if the cheap, coal-fired and hydropower
capacity comes on stream as expected. Going forward, restoring profitability and efficiency to
such companies as CEB constitutes a crucial step in hardening budget constraints. This in turn
will have significant implications for general competitiveness via the pricing of critical inputs like
electricity while creating pressures for innovation and efficiency.
29
Box 7: Snapshot of Public Enterprise sector in Sri Lanka
The state-owned or public enterprise sector in Sri Lanka has been an important part of the economic policy
debate in the country for the last thirty years. Before the first wave of economic liberalization reforms in
1977, over 60 percent of manufacturing was in the public sector and accounted for half of all
manufacturing employment, while public entities accounted for nearly 90 percent of all imports and 30
percent of exports.14 Post-1977 reforms greatly reduced these numbers, but public enterprises (PEs) are
still an important part of the economic landscape.
The government had a controlling interest in 107 public enterprises in 2009. These PEs are involved in
many commercial activities, including finance (26), infrastructure (11), agriculture (9), plantations (11),
construction and manufacturing (16) services (16) and healthcare (6). Taken together, the turnover in PEs
amounted to almost 17 percent of GDP in 2009. However, this may underestimate the true extent of the
influence on economic activity as, for example, the two state-owned banks account for over 50 percent of
the assets of the banking system. Moreover, government has invested directly or indirectly in 52 PE
subsidiary companies and has golden share holding rights in 23 regional plantation companies. The largest
SOEs are the CEB and CPC.
In addition to hardening budgets, an important item on the PE agenda (Box 7 provides a
snapshot of the public enterprise sector) is to develop a strategic vision regarding their role vis-à-
vis the private sector, which as noted above, is something private investors are seeking. The
Government has recently taken over management of Sri Lankan Airlines and Sri Lanka telecom,
taken ownership of Sri Lanka Insurance Corporation and Shell Gas, and land ownership of Lanka
Marines Services and Waters Edge Ltd. It is important clarify the state of play regarding these
specific companies and related future plans.
d. Infrastructure and Human Capital
Public investments in infrastructure and human capital need to be linked to Sri Lanka‘s
anticipated future sources of growth. At the macroeconomic level (and as captured in the results
of the simulation exercise), long run per capita growth is driven by TFP growth, growth in the
labor force and human capital and capital accumulation as influenced by savings, domestic and
foreign. At a more micro level, growth will be driven by the investment decisions of private
actors in agriculture, manufacturing and services. One view expressed during interviews is that
Sri Lanka is too small to permit manufacturing to become a significant driver of long-run growth.
Another view commonly expressed was that there is a shortage of low-skilled workers; on the
14
World Bank (2004).
30
other hand, it would be relatively easy to attract high-skill workers back to the country from the
diaspora. Further, raising funds even in large volumes was not seen as a serious problem.
The government itself is positioning services as the future engine of growth. Its
development policy framework highlights the importance of bolstering infrastructure for
achieving its economic growth targets via the five hubs concept—a naval hub, an aviation hub, a
commercial hub, an energy hub and a knowledge hub in South Asia. In this connection, IMF
Staff note in the 2010 Article IV Consultation that Sri Lanka‘s strategic geographical location and
comparative advantage in services could be the engine of growth in the medium-to-long term.
The 2011 budget sets public investment at 6.5 percent of GDP in the medium-term
expenditure framework. While fiscal consolidation efforts will continue, the government has
made it clear that public investment spending will remain at this level. In fact, public
infrastructure spending has been significant in recent years. Donor commitments since 2005 have
totaled 20 percent of 2010 GDP, although actual disbursements have been half of that amount
(see Table 3). The five main areas of commitments are: roads, power and energy, water supply
and sanitation, railways, and ports and aviation. The main donor in each area is: Japan in roads,
China in power and energy, Japan and the ADB in water supply, India in railways, and China and
the ADB in ports. Overall, China and Japan are the two largest financiers of infrastructure in the
country. Some of the signature projects are the Hambantota Port (China), the Southern
Expressway (Japan/ADB) and the Puttalam Coal Power Project (China).
Table 3. Sri Lanka: Infrastructure Financing, 2005 -2010 (US$, millions)
Category Commitment Disbursement Key Donor
Road Sector 2,553 1,293 Japan
Power & Energy Sector 1,886 1,311 China
Water supply and sanitation 1,168 657 Japan/ADB
Transport Sector - Railways 1,165 n.a. India
Ports and Aviation Sector 1,136 564 China
Total 7,907 3,825
Source: Ministry of Finance
31
However, positioning services as an engine of growth would require significant
investments in human capital as well as the ability to attract talent from the diaspora. In this
connection, it is worth noting that even traditional services such as tourism can be upgraded, for
example by adopting more sophisticated forms like medical tourism.
VI. CONCLUDING REMARKS AND POLICY PRIORITIES
This paper has drawn upon cross-country experience and economic theory to draw out
the policy implications of GoSL‘s macro-fiscal vision announced after the cessation of hostilities.
The vision, set out in the introduction, includes the following goals: doubling nominal US dollar
per capita income; cutting fiscal deficits and government indebtedness substantially; lowering
inflation; and growing at 8 percent per year over the medium term. Policies formulated to
achieve these multiple goals must ensure consistency. For example, allowing the rupee/dollar
rate to appreciate in real terms as it has in the recent past will help to double per capita nominal
dollar income and speedily reduce government indebtedness (since close to 45 percent of
government debt is denominated in foreign currency). But this approach will lower
competitiveness and jeopardize the 8 percent growth target, in turn impeding continued poverty
alleviation. An effective way of ensuring consistency would be to establish a hierarchy among
the various goals with the 8 percent growth given top billing. This would be in keeping with
GoSL‘s emphasis on enhancing welfare and inclusion. It would also automatically help attain the
dollar per capita income target. Similarly, the fiscal and debt targets should be viewed not as
ends in themselves but as facilitating faster growth. Given this hierarchy, three sets of policy
priorities emerge.
The first policy priority is to increase the national savings rate. The simulation results
demonstrate that converting the peace dividend into sustained 8 percent real GDP growth will
require a national savings rate of above 40 percent of GDP even if TFP grows at 1.75 percent per
year compared to the historical average of 1 percent. This represents a substantial increase from
current savings rates of around 25 percent. Adhering to or even exceeding the government‘s
32
target of raising its savings rate to 1.5 percent of GDP will obviously help in this quest. At the
same time, attracting FDI and skilled human capital from the Sri Lankan Diaspora will make a
big difference. Both will help to take the pressure off national savings rates by essentially
tapping foreign sources for augmenting physical and human capital.15
The second policy priority is to create conditions for faster growth which will make it
easier to attain higher savings rates. This can be achieved in two ways. The first is to ensure
that the government raises its primary fiscal surpluses, which must be done in order to meet its
target of lowering government indebtedness, in a manner that is growth-promoting. For example,
cutting security expenditure as part of the peace dividend and reversing the trend decline in fiscal
revenues by tax base broadening and improving compliance would be far preferable to cutting
government capital expenditure or raising marginal tax rates in terms of long-run growth.
The second way of spurring growth is to create conditions for faster TFP growth. For
example, if TFP were to grow at 2.5 percent per year compared to the historical record of 1
percent, the savings rate needed to support 8 percent growth comes down to less than 30 percent.
This would not be easy to do since there are few countries which ever attain this magnitude of
TFP growth on a sustained basis. Nevertheless, considerable opportunity exists for speeding up
TFP growth through the implementation of hard budget constraints and competition, as discussed
in section V on the microfoundations for growth. In particular, a companion study shows that
there is ample scope for quickly increasing import competition. Nominal protection rates are
high in Sri Lanka.16 Dispersion is also high, obscuring price signals for resource allocation.
Export outcomes have been fairly stagnant over the past couple of decades and there has been
little dynamism apart from garments—but even garments is now an old story. Fostering outward
orientation and increasing import competition is probably the most powerful policy instrument
15
NB: The simulation results already allow for foreign savings to be tapped in the form of a current
account deficit (CAD) of approximately 4 percent of GDP. Attracting large amounts of FDI may permit a
higher, sustainable CAD.
16
See Kaminsky and Ng (2012).
33
available to GoSL to set off faster TFP growth. It is important to harden budgets for the public
sector as well to ensure its efficient operation and the provision of infrastructure services in
power, transport, ports and communications at internationally competitive prices.
The third policy priority is to transmit unequivocally positive signals to the private
sector about its role as the engine of growth going forward. Doing so is crucially important for
two reasons. The first is a pragmatic one. Sri Lanka‘s government balance sheet is heavily
constrained by indebtedness and the desire to lower this significantly over the medium term,
implying that much of the needed additional investment will have to come from the private
sector. The second reason is that experience from countries as varied as India, Kenya and Poland
show that profit maximizing firms operating in an atmosphere of competition (domestic and
especially from imports), hard budget constraints and competitive real exchange rates offer the
best hope for upgrading technology and efficiency in pursuit of faster productivity growth.
The three policy priorities will feed off each other and therefore need to be
implemented as a package. As growth takes off on the back of higher government savings rates
and faster TFP growth, the savings rate is likely to increase, helping with additional capital
accumulation. And both FDI and skilled human capital from the Diaspora are more likely to be
attracted under assurances of inclusion and the maintenance of ethnic peace; a stable
macroeconomic environment; and unambiguously positive signals for the private sector.
To conclude, faster growth needs to be made the centerpiece of GoSL‘s vision. While
reducing fiscal deficits and government indebtedness are important, these targets should not be
seen as ends in themselves, but rather as promoting economic growth. Ultimately, it is sustained
fast growth that will enable all the other targets—including the doubling of per capita dollar
income and reducing government indebtedness—to be achieved in a lasting manner.
34
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36
Annex 1: Composite Real Interest Rate and Inflation Tax on Debt
Composite real interest rate:
The composite real interest rate refers to the in the following difference equation for the ratio
of government debt to GDP:
(A1) , where:17
d is the ratio of end-year government debt to GDP
pd is ratio of primary fiscal deficit to GDP
g is real GDP growth
rc is composite real interest rate
t is subscript for year.
In equation (A1), is an amalgam of the real interest rate and real exchange rate effects. Assume
there are only two currencies: local currency (Rs); and dollars ($). Let:
nominal interest rate on rupee debt t =
nominal interest rate on $ debt =
Note that is the dollar interest rate. To get the rupee equivalent rate, , we adjust for exchange
rate gains/losses. Let X denote the Rs/$ nominal exchange rate and D$ dollar debt expressed in
dollars. Then:
= + (The numerator of the second term on the right-hand-side of this
equation is just the exchange rate gain/loss in Rs). Hence we get:
, where is the rate of depreciation of the Rs/$ rate (this equation is just standard
interest parity).
Now get the composite nominal interest, , which is just a weighted average of and :
, where:
w is the weight of rupee debt in total debt at the end of the previous year given by w = , where
is rupee debt at the end of the previous year and is total debt at
the end of the previous year in rupees.
Then = - 1, where is the percentage change in the GDP deflator.
NB: A faster way of calculating ic is to use the formula
.
17
In this simple formulation, we leave out privatization revenues and abstract from factors such as bailout
costs, which in addition to the fiscal deficit could add to government debt.
37
Inflation tax on Debt (ITD):
(A2) in percentage points of GDP.
To see why the inflation tax applies to total debt, go back to (A1):
(A1)
- 1, where is the composite nominal interest rate.
= = .
Numerator of the last expression immediately above can be rewritten:
w(
Hence, .
The intuition is that higher inflation would be offset by higher nominal interest rates and
higher expected exchange rate depreciation. So what you gain in inflation, you lose on higher
nominal interest rates on rupee debt and higher depreciation on $ debt. Plugging the
expression for rc into (A1) and separating out the effects of inflation gives (A2).
38
Annex 2. Savings and Growth in Sri Lanka: Simulation Methodology
To illustrate the linkages between savings and growth in Sri Lanka we follow the methodology
presented in Hevia and Loayza (2011). They use a simple setup that consists of a single sector
open economy model where output is produced by combining capital and effective units of labor
inputs. Effective labor grows by increases in human capital (years of schooling) and the growth
rate of the workforce. The following equation, that links growth rate of output per capita to the
national saving ratio, the growth rate of productivity, the growth rate of the workforce, the
increase in human capital and the capital-output ratio, is parameterized using Sri Lanka data:
where is the growth rate of per capita output, is the growth rate of productivity, is the
growth rate of the population, is the growth rate of the labor force variable (ratio of working
age population to total population, which varies through time with changing demographical
patterns), , where exp(.) denotes the exponential function, is used to express labor in
efficiency units per worker with z years of schooling (an index of human capital), y/k is the
output-to capital ratio, α is the share of capital in total income, δ is the depreciation rate, σ is the
national savings to output ratio, and β is the ratio of net foreign liabilities to GDP. This equation
indicates that per capita output growth is positively related to productivity growth, working age
population growth relative to population growth, human capital growth, and the national saving
ratio.
A brief description of the sources and the calculations behind the parameters required to simulate
the model for Sri Lanka‘s economy follows18:
Capital accumulation and depreciation rate. The current capital-output ratio: = 1.314.
This is the ratio estimated for the year 2010, using a perpetual inventory method to accumulate
investment in order to produce a measure of the capital stock. Given the war-related destruction
of factories, transport facilities, buildings, and other forms of capital, a fixed and relatively low
depreciation rate (0.04 - 0.08, as in most of the literature) is not reasonable. The depreciation rate
to varies in the model, and in order to identify it, a constant rate of TFP growth equal to 0.0107 is
assumed – i.e. the average reported for Sri Lanka in the last decades by Jorgenson and Vu (2005),
Collins (2007), and Son (2010). The capital share in output: = 0.35. This is the average across
countries that Bernanke and Gürkaynak (2002) obtain using adjusted factor payment data from
national accounts. There is no comparable Sri Lanka-specific estimate for the capital share.
Education and human capital. The annual increase in education: = 0.05104.
Education is proxied by the average number of schooling years in the adult population. This
estimate for the annual increase in schooling is taken from the Barro and Lee (2010) dataset and
corresponds to the average annual change for the period 1990-2010. The annual rate of return to
education: = 0.07. This rate of return is used in Bernanke and Gürkaynak (2002) and Collins
(2007) in their growth accounting exercises, which also consider the average number of schooling
years in the adult population as the proxy for education (and human capital in general).
18
For details, see Hevia and Loayza (2011).
39
Labor market. The annual growth rate of the labor force is obtained from the future
demographic projections for Sri Lanka population aged 15-70 years old, presented in United
Nations (2011), World Population Prospects: The 2008 Revision.
Current account sustainability. The ratio of net foreign liabilities to GDP, , is assumed to rise
from its current value of 0.45 to 0.60 gradually in 15 years. This approximately corresponds to
the government‘s target of a current account deficit of 4-5% of GDP over the next 5 years and
declining afterwards. The current ratio of net foreign liabilities to GDP is obtained from updating
the Lane and Milesi-Ferreti (2007) database. Official ―international investment position‖ for Sri
Lanka is not available in the IMF‘s Balance of Payments Statistics.
TFP, Real GDP growth, savings rate and TFP growth. The real GDP growth target is set at 8
percent. This target for the medium term has appeared in many Sri Lankan government
publications (e.g. Mahinda Chinthana) and speeches (e.g. 2011 Budget Speech). The initial
national savings rate is 25 percent. Growth simulation results presented in this paper are based on
two scenarios: in Scenario 1, TFP growth is assumed at 1.75 percent, the average TFP growth rate
for the top quarter of countries in a worldwide sample (see Bernanke and Gürkaynak 2002). This
is far above the 1 percent TFP growth rate estimated for Sri Lanka (Collins, 2007, Son, 2010).
For Scenario2, TFP growth is set at an optimistic level of 2.5 percent.
40
Annex 3. Sri Lanka: Business Climate Indicators
(a) Global Competitiveness Report for Sri Lanka 2007- (b) The Global Competitiveness Index
2010 2010/11
Note: From a list of 15 factors, respondents were asked to select the five
Note: The Global Competitiveness Report classify
most problematic for doing business in their country and to rank them
countries in, or transitioning in between, three stages of
between 1 (most problematic) and 5. The bars in the figure show the
economic development: (i) factor driven, (ii) efficiency
responses weighted according to their rankings.
driven, and (iii) innovation driven.
Source:http://www.weforum.org/en/initiatives/gcp/Global%20Competitiv Source: GCI 2010/11, World Economic Forum
eness%20Report/index.htm
(c) Policy-induced and logistics-related barriers in Sri Lanka and other comparator countries in 2010 (%)
INDIA MALAYSIA MAURITIUS KOREA SRI LANKA THAILAND
Nature of Export Da
Procedures Days US$ Days US$ Days US$ ys US$ Days US$ Days US$
Policy-induced barriers 59 50 67 33 71 73 38 12 71 62 64 51
Logistics-related barriers 41 50 33 67 29 27 63 88 29 38 36 49
Nature of Import Da
Procedures Days US$ Days US$ Days US$ ys US$ Days US$ Days US$
Policy-induced barriers 57 53 71 33 79 70 50 12 75 64 77 47
Logistics-related barriers 43 47 29 67 21 30 50 88 25 36 23 53
Source: Calculated from data downloaded from http://www.doingbusiness.org/
41